Take advantage of the fact that the law happens to treat certain creditors better than others.
Bankruptcy law balances the rights of debtors against the rights of creditors. But the law also sorts out the rights of creditors against other creditors.
Certain debts are favored over other debts because Congress decides that for some reason they are more important. The reasons vary with each favored kind of debt. For example, child and spousal support are favored because of the importance placed on the welfare of children and ex-spouses. Income taxes are favored because all the other taxpayers and the whole nation are harmed if taxes aren’t paid.
How These Creditors Are Favored
Bankruptcy law treats these creditors and their debts better than other creditors in two main ways:
- These debts can’t be discharged (legally written off), or are more difficult than normal to do so.
- They must be paid in full in a Chapter 13 “adjustment of debts” case.
To use the above mentioned examples:
- Child and spousal support can never be discharged in bankruptcy. Income taxes can but only if a series of conditions are met, generally allowing only older tax debts to be discharged.
- Any child and spousal support arrearage owed at the time of filing a Chapter 13 case must be paid in full before that case can be completed. The “priority” portion of income taxes—generally those too young to be discharged—must be paid in full before the Chapter 13 case can be completed.
How to Take Advantage of This
If you owe any of these favored debts, one choice you have is to file a Chapter 7 “straight bankruptcy” to discharge all your other debts so you can then have the means to pay the income tax, child support, or other such debt.
But if the amount that can’t be discharged is too large or the creditor is too aggressive or if there are still too many of these kinds of debts owing, Chapter 13 may well be the best solution.
Chapter 13 comes with two significant advantages:
- You are protected from the collection efforts of these creditors as you pay them.
- In most cases you can and must pay each of these special creditors in full before you can pay anything to your other “general unsecured” creditors.
In other words, you can favor the special creditors over your other creditors, often significantly reducing how much the other creditors are paid, if anything. And you’re protected throughout the 3 to 5 years that a Chapter 13 usually takes to complete, which can be very important because these special creditors—again, those owed child and spousal support, and the IRS and state tax authorities—can be very aggressive in their collection methods.
Imagine the following. A debtor named Cindy owes $10,000 in income taxes from the last two tax years, taxes too recent to be discharged in bankruptcy. She also owes $50,000 in “general unsecured” debts—credit cards, medical debts and such. Cindy’s monthly “disposable income”—the amount she can afford to pay beyond her necessary living expenses—is $400, and with her relatively low income her Chapter 13 case will last a minimum of 3 years.
In her Chapter 13 payment plan, Cindy would pay $400 per month for 36 months, or a total of $14,400. If she DIDN’T owe any income taxes, she would still need to pay that same amount, and it would all get divided among her $50,000 in “general unsecured,” resulting in about 29% of that debt being paid (excluding any trustee and attorney fees, for the sake of simplicity).
But since she does owe the tax debt, the first $10,000 would go to pay that, leaving $4,400 for all the rest of the debts. Dividing that $4,400 by the $50,000 in other debts results in only about 9% of that debt being paid.
The point is that the existence of the $10,000 in taxes that could not be discharged did not, in this situation, increase what Cindy had to pay in her Chapter 13 case. It merely reduced what her other creditors received. She was able to pay the taxes in full, in spite of not paying any more into her Chapter 13 plan than if she had owed no taxes, and be protected from the IRS/state tax authority throughout the payment process.